Mises Wire

Why Does US Price Inflation Remain Relatively Subdued?

The yearly growth rate of the US consumer price index stood at 1.9% in August against 1.7% in July, while the growth rate of the price index less food and energy stood at 1.7% in August against a similar figure in July and 2.3% in August last year.

Given that the Fed’s target for the core CPI i.e. the CPI less food and energy is 2%, this has prompted some experts and Fed policymakers to seek answers as to why price inflation remains subdued in the midst of a declining unemployment rate and prolonged economic expansion. The unemployment rate stood at 4.4% in August against 4.9% in August last year and below the so-called natural, or the equilibrium rate of unemployment of 4.5%.

If price inflation hovers too low, it raises the risk of price deflation, which is seen by most experts as bad news. Most experts are of the view that prolonged price inflation below the Fed’s target runs the risk damaging the credibility of the central bank.

However, the main reason for the dilemma as to why the pace of inflation is relatively low in the midst of supposedly strong economic indicators reveals a misleading definition of what inflation all about.

Contrary to the accepted thinking, the subject matter of inflation is increases in money supply. Note that we do not say that increases in money supply cause inflation. What we are saying that increases in money supply is what inflation is all about.

Now a price of a good is the amount of money paid for that good. Hence for a given amount of goods and a rising amount of money, all other things being equal, this would mean an increase in money per unit of goods. The increase in money per unit of goods is a different way of saying that the prices of goods have risen.

Increases in Money Need Not Mean Increases in Prices

Note that the increase in money need not always be followed by increases in prices. For instance, we can have the case whereby if the quantity of goods increases by the same percentage as the quantity of money, then no price increase will occur. This however, does not mean that there is no inflation here. As we suggested inflation will correspond to the rate of increase in money supply.

However, as a rule, we suggest that increases in money supply tend to be followed by increases in price inflation with a time lag. This was the case between 1961 to 1979 (see chart).

Changes in the US CPI followed the lagged changes in money supply by 23 months. Inspection of the chart shows that there was good visual correlation between the yearly growth rate in the CPI and the yearly growth rate of lagged by 23 months of our monetary measure AMS.

Since 1980 until present, the correlation between the lagged money growth rate and the growth rate in the CPI does not appear to be meaningful. During some periods, the increase in the money growth rate is followed by increases in the CPI, and at other times it appears to actually decreases or mildly rises. Also, there are times when a decline in the money supply is followed by an increase in the growth momentum of the CPI.

Some experts have suggested that the break in the correlation between the yearly growth rate in the CPI and the lagged growth momentum of money supply is due to unstable demand for money or unstable monetary velocity.

What matters here is not whether prices in general are following changes in money supply as such. What matters are the increases in money supply which undermine the real wealth generation process.

Following the financial deregulation of financial markets and the massive explosion in banks creation of credit out of “thin air,” the process of real wealth generation has come under severe pressure.

This is because increases in money supply sets in motion an exchange of nothing for something, and this amounts to the diversion of real wealth from wealth producers to non-wealth generating activities.

Note that the "Austrian Money Supply" (AMS) to its trend ratio (the trend calculated from January 1959 to December 1979) hovered very closely at around 1.0 between 1959 to the early 1980’s. Since early 1980’s this ratio has been rising visibly, climbing to 2.2 by October 2016 before closing at 2.1 in August 2017.

We suggest that the massive increase in money supply has likely severely weakened the process of real wealth generation and thus the pool of real wealth.

The diversion of real wealth from wealth generators to various non- productive activities is another expression for the misallocation of resources.

Furthermore, the monetary pumping has intensified by the Fed’s massive pumping since 2008 in an attempt to prevent the US economy sliding into a deflationary hole.

Now, when the pool of real wealth is expanding the increase in money supply appears to provide real funding to both wealth generating and non-productive activities.

Once the pool becomes stagnant or starts to decline, increases in the growth rate of money supply cannot display any longer the illusion that the increase in money supply can set in motion real economic growth. (Note that money is just a medium of exchange and cannot grow an economy, it can only facilitate the transfer of goods from one individual to another individual).

Note that the pool of real wealth, which funds various economic activities, determines the overall “economic pie” at any point in time. Obviously then, if the pool of real wealth is stagnant or declining, the “economic pie” must also follow suit.

In this setup, competition among companies to protect their market share is likely to force price reductions of goods and services.

In addition, the attempt by various companies to stay solvent might force them to lower prices in order to expand the volume of sales to secure profits.

This of course also means that various activities that have emerged on the back of the previous expanding pool of real wealth now would have to shrink or disappear altogether.

We can thus conclude that the emerging downward pressure on the prices of goods is in response to either a stagnant or declining pool of real wealth.

Once a general decline in the prices of goods emerges because of a stagnant or declining pool of real wealth, any attempt by the central bank to reverse this general decline in prices will only weaken the pool of real wealth further, thereby prolonging the economic hardship.

A better way out of these difficulties is to allow the businesses to get along with the buildup of real wealth whilst at the same time curtailing the central bank involvement in the economy by means of monetary pumping and the lowering of interest rates.

As the buildup of the real wealth, gains pace, this enables various activities to emerge again. This means the emerging activities are likely to be of a wealth generating nature – they are going to be self-supporting and do not require the central bank support by means of monetary pumping and the lowering of interest rates.